Mark Zuckerberg has just massacred his critics

Annoyingly, Mark Zuckerberg, chief executive of Facebook, has managed to defy the sceptics. I say annoyingly because I was prominent among them when he floated the social media company just over two years ago. Initially I was right; the IPO was botched, and amid worries about the company's apparent failure to catch the mobile wave, the shares plunged.

Zuckerberg took note, and paid big time to get into the mobile space. The shares have been motoring ever since, and following a much better than expected second quarter earnings report yesterday, they've reached a new all-time high. Is this justified?

On conventional valuation yardsticks, virtually all tech stocks, including Facebook, look horribly expensive. Facebook itself trades on nearly 80 times reported earnings, a valuation reminiscent of the dot.com bubble in the late 1990s. Nobody needs reminding that this ended very badly.

In a bubble, investors will chase anything that happens to be part of the latest craze. Most of it will be rubbish, but among the no-hopers there will be some treasures. The winners are those who can rapidly establish a market lead, build on it, and eventually begin to monopolise the space. From hundreds, or even thousands of hopefuls, you eventually end up with just a handful of winners, and usually one or two dominant ones – think Google in search, or Microsoft in the early stages of the desk top computer revolution. Yet these winners tend to be hard to spot at the birth of a new industry, hence the indiscriminate nature of much investment.

Warren Buffett has a nice analogy for this form of investing. At the start of the twentieth century, there were apparently 2,000 auto companies in the US. "So how do you pick three winners out of 2000?" he asks."I mean it’s not so easy to do. It’s easy when you look back, but it’s not so easy looking forward. So you could have been dead right on the fact that the auto industry would do well, but if you’d bought companies across the board you wouldn’t have made any money, because the economic characteristics of that business were not easy to define.

"I’ve always said the easier thing to do is figure out who loses. And what you really should have done in 1905 or so, when you saw what was going to happen with the auto is you should have gone short horses. There were 20 million horses in 1900 and there’s about 4 million horses now. So it’s easy to figure out the losers, you know the loser is the horse. But the winner was the auto overall. But 2000 companies just about failed, a few merged out and so on."

At this stage, Facebook looks like one of the winners. Certainly it seems to be justifying the faith that investors are placing in it. Even so, it's going to have to do exceptionally well to fulfil these hopes. As things stand, Facebook trades on roughly 80 times reported earnings. For the S & P 500, the earnings multiple is under 20. This latter valuation can be taken as a reasonable guide to what investors are prepared to pay for big, mature companies which are past their major growth phase, but can be expected to pay a reasonable income out into the future.

Facebook is still a very young company, and in terms of employees if not value, a comparatively small one. Yet companies age fast in these industries. Microsoft took around twenty years to reach maturity. With social media, we can bank on much less. In any case, for Facebook to justify its present premium rating – or in other words, for its earnings multiple to be reduced to that of the current average for the S & P – would require more than 7 years of 20 per cent per annum compound growth in earnings. This is not impossible, but it is quite an ask for any company to effectively quadruple its earnings over a seven year period, which is effectively what's required.

Facebook may or may not be one of the winners, though it seems doubtful it will ever catch Google. At this stage, the same cannot be said of that other one time darling of social media – Twitter.